Lessons of Enron

Enron Lesson No. 2: Special Purpose Entities

April 11, 2011

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Andrew Fastow, who rose to become the CFO of Enron Corp, enters the courthouse during his trail.

Special purpose entities, or SPEs, played a pivotal role in Enron's culture of concealment and financial engineering and as a result is Lesson No. 2 in CreditPulse's special series, Lessons of Enron."Complex dealings with itself."

In 1987, a former McKinsey & Company partner named Lowell Bryan became one of the innovators of something called securitization, a process of pooling loans together and selling them to outside investors in the form of a security, according to the bestseller Enron book The Smartest Guys in the Room by Bethany McLean and Peter Elkind. According to the book, Bryan wrote at the time that "securitization's potential...is great because it removes capital and balance sheets as constraints on growth."

SPEs are complex, off-balance sheet financial structures that are setup to contain securitized assets or debt that is in turn sold to investors with the cash coming back to the company. In it's 2007 annual report, Citigroup defines SPE as "...a vehicle designed to fullfill a specific limited need of that company that organized it." One of the original purposes of SPEs was to isolate and manage risk (see accompanying list) but Enron used them to "keep fresh debt off the books, camouflage existing debt, book earnings or create operating cash flow," according to the book.

In much the same way that Jeffrey Skilling, who also came from McKinsey & Company, saw the need for mark-to-market accounting in order to make Enron's numbers more subjective than objective he also saw where securitization would help the Enron balance sheet and decided to look for someone who could put the fancy technique to use. Skilling hit the jackpot when through a search firm he found a mid-level executive at Continental Bank in Chicago named Andrew Fastow.

Fastow, who was exposed to some of the first securitized loans at Continental in the late 1980s, was hired on December 3, 1990 and immediately began work on the very first SPE for Enron and probably one of the first non-bank SPEs ever called Cactus, which was completed in 1991, according to the book.

Cactus was created for the financial services division of Enron that Skilling was running at the time called ECT. In Cactus, Enron bundled $900 million of mostly borrowed money that it was loaning to struggling gas producers and sold shares of it to high-powered investors that included General Electric, according to the book. As a result of the Cactus SPE, the debt for the loan never appeared on Enron's balance sheet, although it was still owed, with the investment cash going back to Enron. [In later years Enron would report the investment cash from SPEs as operating cash even though it had nothing to do with operations.]

The next SPE that Fastow created for Enron's ECT division was called JEDI. This was a $500 million SPE that was made up of $250 million cash from the California Public Employees Retirement System (known as CalPERS) and $250 million of Enron stock. The cash received from selling this investment vehicle was used by Enron to make "energy-related investments" but structuring the deal through an SPE allowed Enron to keep any reduction in shareholder's equity off the balance sheet.

But those early SPEs were just the beginning. Enron was soon creating SPEs on top of SPEs that were so complex and interconnected that unraveling one transaction would mean unraveling a half-dozen others. "It looks like some deranged artist went to work one night," said Enron's post-bankruptcy CEO Steven Cooper, as quoted in the book.

Fastow and his staff, which included accounting and finance gurus Ben Glisan and Michael Klopper, would go on to create 3,000 separate corporate entities with more than 800 of them located offshore, according to the book. From 1997 to 2000, Enron's balance-sheet assets grew by 50 percent while it's off-balance sheet assets doubled. With names like Chewco, Raptor, Rawhide, Fat Boy and Deathstar, Enron began devising SPEs for just about every sitution that involved hiding debt and increasing short-term cash flow. Citigroup and J.P. Morgan Chase facilitated the investment side of many of these SPEs.

The evolution of SPEs at Enron is remarkable because by most accounts the vehicles were not widely used by other companies at the time. In fact, the Wall Street Journal never even mentions the term special purpose entity or SPE in its feature article of the Enron bankruptcy, which ran on December 5, 2001. The article used the term "partnerships" to describe the many entities that were used to hide debt and generate short-term cash.

On October 31, 2002, the U.S. Department of Justice indicted Andrew Fastow on 78 counts of fraudulent conduct. On January 14, 2004, Fastow pled guilty to two counts of wire and securities fraud and was sentenced to 6 years in prison, followed by two years of probation and the forfeiture of $23.8 million in family assets. Fastow is currently serving out his sentence at a federal penitentiary in Louisiana. He is scheduled to be released December 17, 2011.